Notes on the Economy – 12/13/10

William Dunkelberg

Professor of Economics at the School of Business and Management, Temple University (Formerly Dean of the Fox School of Business)

Learn more about Prof. Bill Dunkelberg.

The Financial Crisis

1.When the financial crisis struck in the fourth quarter of 2008 and our leaders warned of the risk of a depression, consumers reacted in a totally logical way – they voted in a new management team for USA Inc. in the election and raised their saving rate (out of disposable income) from near-zero to about 6%, depriving businesses of about half a trillion dollars of sales. The math is simple. Disposable income is equal in magnitude to about 70% of GDP, or $10 trillion dollars.  Each percentage point of disposable income saved (not spent) is about $100 billion in spending.  Changing the saving rate from 1% to 6% means a reduction in spending of about $500 billion.  This sent the economy spiraling down in the fourth quarter and the first quarter of 2009, two very bad quarters indeed.  Of course, saving more (including repaying debt) is a logical response to fear and uncertainty and, in the long run, is good, since savers are the source of all capital funds.  These funds provide loans and capital to businesses and to governments that borrow the money.  If you don’t save and put some money in the bank, the bank cannot make a loan to a small business to expand and hire.  Since we don’t save much, however, we are continually borrowing the savings from other countries (like China and Japan) to satisfy the demand for funds by our governments (federal, state and local) and private enterprises.  Our total federal debt alone is now over $13 trillion.

All that borrowing has permitted us to “live beyond our means”, borrowing money to buy stuff we want and finance things we want to do and make promises that we don’t have enough money to keep.  Our governments never tax us sufficiently to pay for all the expenditures and promises they make on our behalf.  Firms borrow money, but, overall, use the money in “productive” ways that allow them to repay their loans.  Except for the occasional toll road and fees to use parks or import taxes, our governments only have tax revenues to depend on to pay for what they do.  Unwilling to “charge us” enough to pay for what they do, governments continue to borrow money, unwittingly competing with the private sector for our savings.  Savers, collectively, always face the choice of lending their savings to private businesses (bonds, stocks) or to the government (Treasury bonds, municipal bonds etc.).  The more the government takes, the less we have to invest in raising worker productivity and growing our incomes.  Only the willingness of savers in other countries to lend us their savings has allowed us to “have our cake and eat it too”, to consume at record rates and still have the funds to support the investment needed to grow the economy.

Over time, the cost of maintaining this debt rises. The debt is continually maturing and has to be refinanced.  If interest rates rise, the cost to taxpayers of maintaining the debt will rise as well.  An increase of 1 percentage point in the rate of interest on $13 trillion of Treasury debt adds $130 billion to our financing cost, which must be paid with taxes (or more borrowing!).  That’s about $400 per person each year.  Of course, added to that burden is the interest cost on any new borrowing, $3 trillion in new debt added over the last two years to our federal debt alone.  Eventually, the burden becomes “unbearable” and economic and political conditions “disintegrate” as is happening in many “over-indebted” countries as well as in many local governments in the U.S.  It’s not a happy ending and unless we stop “living (and promising) beyond our means”, we will end up in a bad way.  The longer we wait, the worse the ending will be.

2. Hope For “Change” (In Congress) Didn’t Improve Confidence, Maybe Reality Will.

Unhappy shareholders voted for a major change in the management team for USA Inc. (although it is hard to understand some of the choices made in states where serious fiscal reform is needed) with the hope of seeing a different set of policies implemented to “right” (pun just noticed by the author) the ship.  The old team dealt with the jobs recession by spending their time on legislation for cap and trade, card check, health care reform, union bail outs (GM and Chrysler), a “stimulus” bill that was not designed to stimulate but loaded with pork and to require the employment of union workers on stimulus projects (or none at all since funding would be denied to non-union companies), a 10 percent increase in the minimum wage which cost half a million teen jobs, and other policies which ordinary shareholders could not understand as dealing with the immediate problems of the economy.  And then there were the frighteningly large deficits and profligate states on the verge of bankruptcy with striking workers that were far better paid than their private sector counterparts.  Ordinary citizens found this troublesome and confusing.  Although the expectation of a major change in Congress seemed to be widely accepted, that did little to improve confidence. Consumer and small business owner sentiment remained depressed.  Perhaps more concrete evidence of appropriate “change” is required.

And, the day after the shareholder vote, the Fed embarked on an uncertain policy course to expand its balance sheet to near $3 trillion by buying more Treasury bonds.  Just how much this will lower long term interest rates is unclear since we are operating “at the limits” of the range of rates and liquidity.  Just how much spending will be stirred by, say, a quarter point reduction in rates (if even that much is achieved) is also unclear, but the presumption by most is “not much”.  With historically low rates, who hasn’t already refinanced or bought a house that has the interest and ability to do so?  The Fed also seems to have forgotten that thousands of smaller banks that don’t have access to “cheap money” have established floors on loans and Fed action is unlikely to push through them, especially since most market participants expect rates to eventually go higher.  In its rush to support debtors, the Fed has abandoned the saver, cutting billions in interest income for savers, forcing them to invest in long bonds to get any yield at all and setting them up for future capital losses as rates rise (or inflation ravages the purchasing power of their bonds).  With over a trillion dollars of excess reserves now being held for banks at the Fed, it is hard to see QE2 doing much other than adding to those excess reserves.  If the current trillion in excess reserves can’t be lent out, what’s the banking system to do with another half trillion?  If the Fed buys stuff from you (including Treasury bonds) and writes you a check, what will you do with it?  Put it in the bank?  This adds to excess reserves.

The private sector will continue to slog ahead, after all, the population grew by another million or so, they need food, haircuts, transportation and the like.  Indeed, it is new firms started to serve population growth that account for a lot of the job growth in America (Japan and Western Europe are missing this source of growth).  Although Congress has erected many “headwinds” for growth (and a lame duck session could do more), the new management team may provide some relief and reduced uncertainty.  This would certainly promote more growth.